California Anti-Deficiency Laws May Wipe Out Post-Foreclosure/Shortsale Income Taxes

A new nuance may have been created by the passing of the 580e law (anti-deficiency of short sales). An untapped section of the real estate market may now be ripe for the taking. Many might recall, during the early 2000's, that people decided to refinance their current property and purchase multiple other rental properties. I like to refer to these people affectionately as "monopoly men". These were people who thought it a good idea to refinance their personal residential mortgage, and invest in "rental properties." Problem was, when they busted, they believed they were going to have to either claim bankruptcy or "tough it out" and keep the properties. Now there is an exit strategy for these people.

Fact: Most of the Monopoly Men were taking financial risks to invest in these properties.

Fact: Most of the Monopoly Men would sell all of their failed rental properties if they could because they are having to supplement the payments from their own non-rental income.

Fact: The number one reason that they have not done a short sale of their rental properties is because of fear of the tax ramification due to their properties not being eligible for the Mortgage Debt Forgiveness Act.

Law: The IRS Code states that the foregiveness or cancellation of "non-recourse debt" is not gross income. "Non-recourse debt" is controlled by state law, and generally means debt for which the lender has no recourse against the borrower if the security is insufficient to satisfy the debt upon foreclosure. Code of Civil Procedure Sections 580b, 580d, and now 580e specifically states that the lender cannot seek any collection or action for deficiency after a foreclosure or short sale. So, these California laws may convert recourse mortgages into a non-recourse debt upon the completion of a forclosure or short sale. THEREFORE, IF AN INVESTOR SHORT SALE'S AN INVESTMENT PROPERTY, THERE MAY NOT BE ANY TAX LIABILITY!!!

Argument For Non-Recourse Conversion: Normally, forgiven or cancelled debt is gross income, for which a person has to pay taxes on. However, under the IRS definition for "non-recourse" debt, there is only a taxable event if the lender can hold the borrower personally liable. Sections 580b-580d make it infatic that once the lender completes non-judicial foreclosure, or a short sale, there can be "no deficiency," meaning the lender cannot hold the borrower personally liable. Thus, at the time the event occurs (completion of non-judicial foreclosure or short sale), California law forbids recourse by the lender. This "conversion" meets the definition of nonrecourse debt under the IRS Code, and should be taxed under the non-recourse rules.

The non-recourse rules take the cancelled debt and re-classifies it as capital loss. This means instead of paying taxes, the client will have a new capital loss write off that he or she can use for up to three years against any capital gains.

Argument Against Non-Recourse Conversion: I have been reading many articles by tax professionals, that are stating that they do not believe a nonrecourse conversion is the appropriate tax analysis, however, the tenor of the articles appears to be ones of avoiding professional liability, then actual analysis of the law. There are provisions for sanctioning accountants for taking "overly agressive stances" on tax returns, which I believe may be tainting the conversation. The fact that there has been no private letter ruling, nor a court case directly on point may be what is giving everyone pause in the tax community.

With that caveat, the argument against conversion, is that the purpose of Sections 580b-580d was not to convert taxes, but to protect against private civil actions by lenders after taking non-judicial action in a foreclosure or short sale. Although the IRS has recognized that mortgages can be converted from recourse to nonrecourse, that is usually through a written document, and has not been recognized by any court that it happens at foreclosure.

Analysis: Although there have been no cases, or private letter rulings, nor any guidance whatsoever from the IRS, these arguments stand on shaky ground. First, just because a law was specifically created for one reason, it does not mean that they cannot have additional consequences, whether intentional or unintentional. Further, the California Supreme Court ruled that the anti-deficiency laws were created so that homeowners would not lose their home and also be leveled with large deficiency payments (which can include taxes) for the purposes of avoiding a deepening of depressive economic times. (See Roseleaf Corp. v. Chierighino) Tax relief is a sure fire way avoid adding to economic depression.

Second, mortgages can be converted. The IRS has recognized that, and especially with a short sale, where there is a written agreement to sell, that document (even though silent as to taxes) may be enough of a writing. However, operation of law will also be sufficient. The law itself, not contract, is sufficient to convert the mortgage to nonrecourse. The opposition argues that a law converting recourse mortgages into nonrecourse mortgages violates the Constitutional prohibition against interfereing with existing contracts. However, in California, a mortgage is simple a conditional promise to pay any deficiency upon judicial foreclosure. (see Pacific Valley Bank v. Schwenke). When the lender completes a non-judicial or a short sale, the lender has not completed to condition precedent to activate the contratual obligation to pay a deficiency. Therefore, the mortgage contract has not been interferred with, and the law would not violate any Constitutional prohibition. The IRS may also argue premption, which is the principle that federal law trumps state law. This argument also fails because although federal tax law does trump state law under premption, the federal law squarely places the mortgages (and their ability to receive recourse) under the exclusive jurisdiction of state law. There again, California law would prevail, and the law can be considered the conversion act.

Lastly, just because it has not happened before, is a silly way to argue that the conversion is not actually occurring. It is a kin to stating that the earth is round before Gallelo proved otherwise, or that the seperate but equal doctrine could not be overturned before Brown v. Bd of Education was decided. What is needed is either IRS guidance on the issue, or a private letter ruling. The problems are that IRS guidance is excruciatingly slow in coming, and private letter rulings are very expensive. So, we will all have to wait and watch for a case to come down the road and tell us the answer we are all excited to see.

Who Cares? Realtors! This means that realtors may now be able to market to these Monopoly Men. Think about it. One client, three short sale listings. Triple your pipeline with only one third of the complaining clients.

Who Else? CPAs. Now they are more valuable to the real estate investor than ever. Most of them haven't even put this together yet. All they have to do is take the 1099c amount from the bank and put it on the Capital Loss Schedule (Schedule D) of their client's regular 1040 income tax return.

This guide is for educational purposes only, and shall not be relied upon for any other usage. Further this guide is not intended to be legal advice, and the author and his firm disclaim any attorney-client privilege, as well as any attorney client relationship between the reader and the author or the author's firm.